3 capital structure 3 capital structure economics has a dualistic nature. whether it is a human...
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CAPITAL STRUCTURE
Economics has a dualistic nature. Whether it is a human quest for certainty
or simply a need to achieve balance, each concept can be defined by its opposite:
supply vs. demand, inflation vs. deflation, Keynesian vs. monetarist, debit vs. credit
and ultimately, risk vs. return. Rarely does one financial thread weave itself
through the random chaos of opposing ideas, and holistically embrace their
reconciliation. That thread is capital structure.
Students often leave college with a set of ideals that readily flourish in a
sanitized, isolated laboratory, only to falter when tested and stressed by real-world
random variation. Rather than abandon those ideals, most students will adapt them
to the vicissitudes of modern finance. For example, if one graduated before 1970,
both high inflation and high unemployment occurring at the same time was
inconceivable: the Phillips curve professed a tradeoff between these economic states
and direct correlation was infrequent. However, by the time the year 1980 rolled
around, inflation and unemployment had been so rampant that economists changed
their own concept of causation; expectations of inflation carried as much
mathematical “weight” as any other hypothesized cause.
When students become “investors,” there is eventual disenchantment with
“fundamentals” because stocks seem to have a ”mind of their own” and rarely
respond to such analysis. Investors become discouraged because some “magic”
combination of sales and earnings fails to beat a competitor who is barely
functioning. Often, the frustration with “chasing earnings” will turn into a
penchant for technical analysis, which at first appears to yield legitimate results -
until the investor realizes that he or she is merely following random patterns made
within the context of a rising market. In this case, “the trend is the friend,” but the
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changes in patterns and transitions are unpredictable. Indeed, if the return were as
high as touted by the software dealers who sell it, technical analysis would attract
major companies like Boeing and GE who would happily forego their eight or nine
percent profit margins in pursuit of “safe” forty percent returns.
Capital structure is firmly entrenched in academic tradition, but is flexible
enough to apply to real world situations; its study can lead to both revelation and
financial remuneration because it is interactive with so many economic disciplines.
The basic concept, however, is not so unusual: movement toward a firm’s optimal
proportion of debt and equity funding tends to propel the stock upward. What is
more difficult to grasp is the balance between risk and return that allows this to
occur. The ability to forecast is not as important as the ability to coordinate
information and identify firms whose leverage is conducive to greater earnings. In
effect, most analysis concentrates on earnings because it is the most correlated
fundamental to stock price. Alternatively, capital structure analysis concentrates on
the context of earnings because it is concerned with both risk and sustainability; the
variation of the return has as much import as the return itself. Without this domain
of risk, profit appreciation can be both deceptive and transient, and beguiling
enough to lose money over.
THE COST OF CAPITAL: MARKET ORIENTATION AND PRACTICAL APPLICATION
The traditional definition of the cost of capital is conceptually vague.
Defined as the amount of return that a business could make on alternative
investments of similar risk, the cost of capital encompasses several implicit factors
that complicate its practical use. Foremost among these is the gauging of “similar”
risk, and the need to price all sources of capital – debt, equity and associated
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variations – at the market rate. Second, the cost of capital does not always have an
“upfront” accounting cost. It is considered an “opportunity cost” that is
comparative in nature, and its only “cost” may be the greater risk taken to generate
more income. Comparative actions that are not pursued may have as much
significance as the actual course of action.
Theoretically, all sources of capital are priced at what the market currently
dictates and implicit in the analysis of comparative investments is the breakdown of
these capital components into relative price levels. By interfacing individual
corporate risk with the prices configured by the current state of the capital markets,
a specific “required rate of return” will be determined. For debt, the return is the
most current interest rate which is multiplied by a reciprocal of the tax rate and
then by the market value of a firm’s debt. Since the price of a firm’s debt will
change exponentially depending on the relative increase or decrease in the newly
negotiated rate, the scope of the calculation is beyond the purview of most investors.
For equity, investors will attempt to determine the expected appreciation of stocks
with equal risk and attach this rate to the market value of the firm’s stock. Each
value can be multiplied by the proportion of its respective component in the capital
structure. If a firm has a 30/70 percent debt to equity, then 30 % is multiplied by
the most current interest rate and then by the incurred tax advantage of (1 – tax
rate) to produce a percentage cost of debt This figure is added to the product of the
percentage cost of equity and the proportion of equity in the capital structure (70 %
in this example). Together, the respective costs of equity and debt are proportioned
by their relative weights in the capital structure to form an aggregate cost of capital.
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Problems arise when the investor attempts to corroborate theory with
reality. Stock prices can be quite volatile and anybody who follows the market can
testify to the futility of gauging a corporation’s required amount of equity from
market values alone. Similarly, investors are not privy to negotiations with
creditors over interest rates nor are market values of debt always determinable.
Moreover, the market will frequently misprice risk over short periods. Thus,
determining capital proportions from market values can even be dangerously
misleading.
Why use market rates to price the cost of capital? In order to gauge the risk
of alternative investments, the investor needs a common denominator. With market
rates, a corporation can observe the direct gains or losses in following a specific
course of action. If, for example, a corporation can issue stock at a high price but
chooses to issue high coupon rate bonds instead, it may incur what is termed an
“opportunity loss” – a measurable outlay of interest expense over and above the cost
of equity. As long as a dollar amount can be attached to any strategic action,
alternatives can be compared and the most cost effective path can be realized.
While the use of capital implies long-term planning and obligation, the
volatility of market rates makes the cost of capital a relative value: it can be
designated as “improved,” or “lower” than competitors’ rates, but it needs other
financial information to corroborate it. To determine capital proportions, for
example, the history of the industry, the types of assets, and the expected size and
stability of earnings must be counterpoised to the current market cost of capital. In
effect, the absolute size of the cost of capital is less important than its relational
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value and its context. In theory, however, the cost of capital is derived from those
relational values.
Adaptations of the cost of capital are improvised throughout this text to
assist the investor in better gauging risk. An appendix in chapter six covers some of
the theoretical underpinnings in determining a “real cost of capital,” and why using
some book values - such as interest expense –may offer the investor a practical
analog.
THE ADVANTAGES OF DEBT
Implicit in the definition of debt is its inherent advantage - the reception of
immediate funds with payment “postponed” until a later date. Any amount of cash-
flow is more valuable in the present than it is in the future because it can be invested
and earn interest. Whenever an account returns more on a loan than it costs, a net
advantage occurs. However, the timing of the inflows is of even greater importance.
Not only are returns greater when the payoff from an investment occurs faster, but
the risk of any loan is diminished because the firm has adequate cash to service
interest payments. Like “just in time” inventory systems, most businesses recognize
the importance of receiving cash-flows at the moment a bill is due. In effect, profits
are enhanced and risk is diminished if payment is made in a timely fashion. When
servicing debt, a profit received this year is much more valuable than the same
profit received next year simply because the firm can take advantage of the “time
value of money” and invest the funds it does not need for servicing the loan.
Besides the time value of money, debt is evaluated by comparison to other
firms. A loan that returns more than its cost may be considered “ineffective,” if a
firm’s peers are returning one and a half times as much. Thus, industry standards
are an important element in evaluating debt. Performance indicators like the
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return on capital are significant, but even more indicative are the average ratios of
debt to equity, and the amount of interest expense relative to long-term debt. When
both returns and leverage ratios are hovering around the industry standard, risk
and return will be commensurate with a firm’s peers. However, when these
measurements are below that standard, the investor can look for one of two
outcomes: either a compensating bounce (turnaround) that lowers risk and propels
the stock upward, or a stagnant indebtedness, which may be accompanied by a sell-
off. A number of mechanisms are in place that confers other advantages:
• 1. Interest is a tax-deductible expense. Interest expense is routinely deducted
from operating income before taxable income is calculated. In fact, the tax
savings are the cost of interest multiplied by the tax rate.
• 2. A long-term loan (over one year) grants tax advantages until the loan is paid
off and may have a stabilizing effect on the firm if cash-flow is especially tight.
• 3. Since interest is tax deductible, the cost of debt is almost uniformly less than
the cost of issuing equity, which can dilute market price.
• 4. Investment with debt may limit the number of shares outstanding ;
performance can be enhanced without burdening shareholders if earnings per
share (EPS) rise.
• 5. Issuing debt rather than equity helps maintain existing control of the
company. Less new shares restricts voting power to the largest current
shareholders. Moreover, more debt on the books will limit takeover attempts
because prospective buyers do not want to be burdened with the obligations of
leverage, i.e., interest expense, restrictive covenants, sinking funds, etc.
Since all debt funds a specific level of assets, taking on debt will save the firm
an amount equal to the tax rate multiplied by the amount of bonds. In effect, the
government confers tax advantages to encourage investment, and then plans to
make up the difference in new income taxes when the investment generates profits.
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Without this tax benefit, the optimal proportion of debt to equity would be less
significant, depending on the risk of insolvency alone.
RISK AND DEBT
While it seems advantageous to pile up debt and use the tax savings for other
investments, a corporation who does so flirts with default. Earnings are often
cyclical, but interest payments must be timely, and once debt is incurred, the
probability of bankruptcy increases exponentially. In fact, the amount of fixed costs
in a production cycle regulates both operating risk and the amount of financial
leverage that can be incurred. Those firms with very high fixed costs may have
earnings that fluctuate more than firms with lower fixed costs, and have a higher
risk of default during economic downturns. Their risk of bankruptcy is higher
simply because their production cycles are more reactive to economic conditions.
Thus, these firms with high “economic” risk are poor candidates for financial
leverage.
One major problem with capital structure analysis is enumerating the cost of
bankruptcy. The term “bankruptcy” has many definitions and covers a wide
breadth of legal states and financial conditions. This text approaches the concept
from the perspective of the corporate common shareholder and always presumes
the loss of shareholder value. It designates a relationship between assets, liabilities
and market value, which by its very nature is probabilistic; market value is affected
by psychology as much as assets are affected by inflation. However, the main tenet
needs to be examined; there is some cost of bankruptcy that is composed of at least
two associated elements: some amount of loss and some probability of default.
Although there may be many other factors, these form the base of a generic model.
Once the “generic premise” is accepted, there is considerable difficulty in
creating a relationship between fixed costs and asset structure to obtain an “amount
of loss.” There are some assets that can be sold in the event of liquidation and some
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assets that do not directly affect the operating capacity of the firm. Moreover, the
market value of the stock above the level of assets is based on the expected ability to
generate income in the future. Thus, the proper confluence between several asset
classes and the amount of intrinsic shareholder value forms an amount of loss.
Default probabilities are created from historical distributions. When the
relationship between typical inputted variables like asset size, or sales stability
changes, the probability is no longer valid. In effect, once a default probability is
ready for the market, it is no longer one hundred percent accurate. The financial
community develops limits of tolerance that accepts imprecision as a given variable.
Ultimately, capital structure analysis rests upon this tolerance for a “ball park
figure,” but must have data that is coordinated to alert the analyst to the presence
of more risk. However, the reliance on default probabilities is in itself “risky”(the
2007 “credit crunch”) because there is risk that cannot be enumerated until the
event occurs. The economic and political risks that are outliers to any “system,” are
very illustrative of this concept; they may affect a firm’s performance more than
any internally generated variable like sales or assets. Thus, to form a “generic cost
of bankruptcy,” we depend on default probabilities and we multiply them by an
estimated amount of loss, but each component part is hypothetical and tentative.
With an increase in bankruptcy costs comes a concurrent rise in the cost of
capital. Investment banks demand more interest on bonds and higher flotation
costs for stocks to mirror the greater risk in a company. The cost of each source of
funding is interdependent on the market for alternative sources. In fact,
proportional increases in debt have a fixed tendency to raise the cost of both equity
and debt as risk becomes higher. This interaction between risk and the cost of
capital is never static and forms the basis of capital structure analysis. When an
optimal proportion of capital sources is achieved, cost, risk, and the
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interrelationship between economic outlook and corporate performance will be
balanced; the firm’s stock price will be maximized.
Inevitably, seeking an optimal capital structure turns into a game of strategic
risk. Since the cost of capital cuts into profitability, firms with too much debt are
usually cash-poor, low-earners with diminished market values. Their inability to
maintain cash-flow perpetuates a chain of loans in which one loan retires another
with little payment of principal. However, those firms who have greater resources
can afford to use more debt in their capital structures which causes less strain on
existing shareholders, enhancing market value. This strategic use of leverage, the
utilization of debt with recourse, allows fewer shares to be issued, contributing to
performance on a per share basis. When projects become profitable, there is less
shareholder investment but greater return, and the market price of the stock
increases.
MATHEMATICAL OPTIMIZATION: THEORY VERSUS REALITY
The theory of capital structure is predicated on the balance between the tax
benefits of debt on one side of a function and bankruptcy costs on the other. This
equality optimizes the proportion of debt to equity at the point where the change in
tax benefits equals the change in bankruptcy costs. In effect, we try to maximize the
function (Tax benefits of debt) - (Bankruptcy Costs). If we calculate the first
derivative of the function and set it to zero, the function is at an optimum and ∆∆∆∆ Tax
benefits = ∆∆∆∆ Bankruptcy costs.
The problem, however, is not in the concept of the function, but in the
definition of variables that interact. As previously mentioned, the term
“bankruptcy costs” is unique to the realm of the amount of loss; each corporate
entity loses something different. Moreover, some of the variables depend on
probability and some are deterministic; they are interdependent nevertheless and
create both variation and uncertainty.
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Ultimately, the need for mathematical certainty is not as significant as the
need to realistically gauge risk and move the firm in the right direction. In fact, the
potential for price appreciation in a stock is much greater when a firm is a long
distance away from its optimal capital structure, but resolutely moving toward it.
Since a stock price maximizes when a firm’s capital structure is optimal, there is
little room for it to move - up or down. In this case, investors might even demand
that the firm take more risk by moving away from the relatively “safe” world of a
stock price optimum and engage in mergers and acquisitions. Wall Street rewards
companies who “defy the odds” by outperforming the market in some special way.
Consequently, firms who seem laden with debt but begin to escalate sales and
earnings, are generally observed to be a long distance from an optimal capital
target; their higher risk of bankruptcy coupled with subsequent improvement
substantiates more investment.
The true optimal capital structure is in a state of flux. In fact, it responds to
so many different variables that it perpetually changes - almost instantaneously.
The reason behind this variation is that it is dependent on external relationships
outside the internal control of the firm. While leverage factors may determine an
estimate of the amount and sources of funding, the foundation of corporate risk is
the inter relationship between long and short-term interest rates, and the equity
market. These relationships change daily. Even if a firm were shut down for a
holiday, its optimal capital structure would change ever so slightly, depending on
the performance of foreign markets.
Fortunately, the analyst does not need a mathematically precise rendition of
an optimal capital structure to make effective recommendations. Several useful
indicators exist to aid in determining whether the firm is moving in a favorable
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direction. Classic measurements like the return on equity (ROE), and EVA®1
(economic value added) can be modified to reflect activity toward an optimal target.
Although the student/investor is encouraged to create a working model and obtain a
“ball park” estimate, such exercises will be laden with at least three discrepancies:
1) A lack of adequate variables 2) Artificial constraints and 3) Too many constants.
However, such efforts can be informative, even if imperfect. They can help the
analyst to understand the components of corporate risk, and especially any changes
thereof.
THE MODIGLIANI - MILLER PROPOSITIONS
Most of our present knowledge of capital structure is merely an extension of
the research done by the team of Merton Miller and Franco Modigliani in the late
1950s. In fact, the function, (Tax Benefits) - (Bankruptcy Costs) is simply a
relaxation of a constraint that they used to determine the incremental value of a
leveraged firm over an unlevered one. In their famous equation V(l) = V(u) + TB,
the value of a leveraged firm was greater than the value of one with an all equity
structure by a factor of TB, which was the amount of the firm’s bonds multiplied by
their tax rate. Since interest is a tax deductible expense, in the absence of
bankruptcy, a firm can increase its value simply by incurring more and more debt.
Without such tax advantages, the value of the unlevered and leveraged versions of a
firm would be equal, which forms the crux of Miller / Modigliani’s Proposition I: In
the absence of taxes or bankruptcy, the value of a firm is independent of its capital
structure.
The second proposition, proposition II, proves that increasing the
proportional amount of debt increases the cost of equity. Since the real rate of
return on debt must cover interest payments before it shows profitability, it is
1 EVA
® is the registered trademark of Stern Stewart, Inc.
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higher than the rate of return on equity by a “risk premium” that pushes the cost of
equity upward. When this proposition is examined in a world of taxes, we can
conclude that the optimal capital structure is composed of one hundred percent
debt. As long as interest is tax deductible, in the absence of bankruptcy, the cost of
debt would always be lower than the cost of equity; free cash-flow would always be
greater with the use of debt. In fact, this extreme “corner” solution forms the
foundation for all further extrapolations of capital structure theory. In essence, we
relax constraints and add variables to derive a realistic hypothesis. By adding
bankruptcy costs, for example, we merely regulate the tendency to use lower cost
debt.
The logic behind proposition II was that the cost of equity reacted to the
increase in debt by rising. When cash-flow is channeled toward creditors and away
from shareholders, as it is when debt is incurred, the risk of owning stock increases;
bondholders must be paid before shareholders receive any dividends.
Figure 3-1
Debt / Equity Ratio
Cost of
Capital
Cost of Debt
Cost of Equity
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Each incremental unit of debt pushes up the cost of equity because it increases the
required rate of return.
THE OPTIMIZATION PROBLEM
While tax benefits are composed of a simple linear function (long-term debt
multiplied by the tax rate), the cost of bankruptcy will adopt a shape that is defined
by its variables. In some models, with a constant amount of loss, it takes on the
shape of the default probability. In other models, the shape may be defined by an
exponentially increasing loss or a linear default probability; each manifestation of
bankruptcy is fundamentally unique. Without a standardized “cost of bankruptcy,”
solving for an optimal amount of debt depends on the combination of variables that
make up the function.
At the very least, the cost of bankruptcy must have a slope that is greater
than TB (Tax Rate x Bonds) or tax benefits will exceed bankruptcy costs at every
level and the model is not operable. Second, the curve should emulate a risk-return
tradeoff and increase at an increasing rate at some point; a modified “S” shape is
ideal because it shows a threshold amount of bankruptcy costs, followed by a rapid
increase and then a leveling off when actual bankruptcy occurs. Last, some of the
shape of the cost of capital curve should be incorporated into the cost of
bankruptcy. While bankruptcy costs do not perfectly mirror the cost of capital,
they should show increasing costs for greater risk just as creditors charge higher
interest rates for more risky loans.
The linearity of the assorted costs of capital in the Miller/Modigliani
propositions was a function of the constraints - especially the absence of bankruptcy
costs. In reality, the cost of capital is regulated by several relationships that create a
jagged curve and limit the amount of debt that a firm can incur. The cost of capital
curve will at first decrease as more debt creates both tax benefits and a larger EPS,
through fewer shares issued. It then moves rapidly upwards as interest expense
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becomes onerous and the firm moves closer to bankruptcy. Thus, the theoretical
underpinnings of the cost of capital will create a curve that in the long run, mimics
the cost of bankruptcy curve as creditors charge more interest at an increasing rate;
past a specific point, each additional unit of debt will increase rates so rapidly that
financial leverage will no longer be cost-effective.
The limiting constraint in any optimization model is the market value of
capital. When a model attempts to optimize the amount of debt, it will match the
amount of capital with the boundaries of the default probability. The greatest
accuracy is achieved within narrow bounds and may not include the given amount
of capital. For example, many default algorithms will allow a greater amount of
debt than the capital limit simply because they are not configured for extreme
values: default probabilities are created from averages and may not be accurate
within the level of debt that is normally used by the company.
Some models shelve the concept of market value altogether and concentrate
on the amount of asset loss that occurs in a typical bankruptcy within the industry.
From twenty to sixty-five percent of assets is a common figure, and these models will
be configured for specific sectors. Default algorithms may be ‘customized” to meet
the needs of firms within an industry and will be more accurate than the generic
algorithms used in this text. Nevertheless, any model will oppose the costs of debt
with its benefits, - a spin-off of the original Miller/Modigliani thesis.
THE PROPOSED IDEAL AND ITS INHERENT PROBLEMS
We can solve the marginal benefits function, ∆∆∆∆ Tax benefits = ∆∆∆∆ Bankruptcy
costs, by finding a level of long-term debt that makes the function equal to zero.
Naturally, long-term debt would be a variable in bankruptcy costs, and we can
satisfy the equation by manually inputting each unit of debt from zero to the capital
limit. When the function , (Tax Benefits) - (Bankruptcy Costs) no longer increases,
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an optimum is found. Alternatively, we can use a linear programming module like
Excels “Solver” to maximize the function. The graphical display would be thus:
Figure 3-2
In this “ideal” depiction, the optimal amount of debt is at point “X” because the
difference between tax benefits and bankruptcy costs are at their greatest point.
The marginal benefits function, ∆∆∆∆ Tax benefits = ∆∆∆∆ Bankruptcy costs is operable
when the slopes of each curve are equal. From the perspective of calculus, the
function, (Tax Benefits) - (Bankruptcy Costs) is maximized when its first derivative
is set to zero. By linking tax benefits to bankruptcy costs through the variable,
“Long-term debt,” we produce a differentiated function. When we subtract this
optimal amount of debt from a given amount of capital, we produce the optimal
amount of equity.
Among the several problems in such a model are:
• 1. Context - Optimization variables are not formulated in terms of corporate
potential, and yet capital allocation depends on expectations, judgment, and
wisdom garnered from historical observations. No optimization variable is
DEBT
$ COST
TB
Cost of Bankruptcy
X
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cognizant, for example, of a marketing strategy that will make a firm an
industry “front-runner.” Another example would be the expectation of
increasing interest rates; an optimization program might lock a firm into a level
of debt that is appropriate at a lower rate, but excessive if rates are expected to
rise.
• 2. Artificiality - Besides the construction of hypothetical variables (amount of
loss), some variables must be held constant when in reality, they would change
dynamically with the level of debt.
• 3. The assumption of appropriate capital.- Few companies have the ability to
match the amount they can raise with actual capital requirements. Any
optimization model works within a given capital constraint which may not be the
optimal one. For example, if underperforming its peers is considered “normal”
performance for a company, a program might optimize debt under the premise
that the firm is earning a ten percent return on capital and not the fifteen
percent of its competitors. However, a true optimal proportion of debt to equity
would bring the return on capital (ROC) up to industry standards. In this case,
either the amount of capital is excessive, or production problems limit the
amount of net income - a problem that is not part of the optimization function.
CAPITAL STRUCTURE AND THE COST OF CAPITAL
Both students and investors get the misconception that the relationship
between the cost of capital and capital structure is based on affordability - that the
price of debt (interest) determines how much debt a firm can incur. Using this
faulty line of logic, a company can have a forty percent debt to equity ratio when
interest rates are down and a twenty percent proportion when they rise. In fact,
firms do take advantage of interest rate cycles to incur more debt but do not
materially change their optimal capital structures; lower rates become an incentive
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to take more risk but are balanced by the diminished earnings outlook that usually
accompanies a Federal Reserve rate cut.
Capital structure has an interactive cause and effect relationship with the
cost of capital. Some of the factors that regulate the proportion of debt to equity
affect the cost of capital. On the other hand, the major portion of the cost of capital
is configured away from the internal dynamics of the firm and is dictated by a
confluence of factors in the greater economy. In effect, an aggregate of the demand
for money (macroeconomics) will determine the absolute level of interest rates while
competitive forces within the company (sales stability, earnings, and assets) will
determine the limits of tolerance - comparatively favorable rates, or rates that are at
the upper-most levels.
The decision to use debt is not so affected by the price of debt, as by the asset
structure of the company - the proportion of fixed assets, and how well the assets
can serve as collateral for a loan. For example, real estate may serve as better
collateral for a bond issue than a more valuable commodity like gold simply because
it is less volatile. The fixed income market is based on dependability, which is
actualized by steady earnings and stable prices; creditors demand from firms’ asset
structures, the same performance that they expect when receiving interest
payments. Thus, large firms with steady incomes and salable collateral can seek
and incur more debt in their capital structures.
Three characteristics of a firm’s asset structure are especially significant:
the stability of sales, operating leverage and capital intensity. The third
characteristic, capital intensity is merely the inverse of the fundamental, asset
turnover, which is: Sales / Assets. When we turn this around to: Assets / Sales, we
obtain a comparative ratio of the degree of fixed assets in a company. Risk is
created by the propensity to generate fixed costs, and higher capital intensities will
require just that - more capital to pay for outdated machinery, management salaries
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and various “overheads.” Firms desire to match the timing of cash-flows from
projects with the type of funding because such a strategy increases return and
reduces risk. Consequently, firms with higher capital intensities will have projects
that encourage long-run profitability and require extended funding. By itself,
capital intensity will affect both operating leverage and sales stability and is very
dependent on the type of industry. However, within those confines, the decision to
fund with equity or debt still exists, and is as much dependent on the risk of physical
collateral as it is on operating risk - which often go” hand in hand”; firms who, deal
with riskier assets will often have the most operating risk.
By Miller/Modigliani proposition II, it is doubtful that the firm can obtain a
level of risk that pushes the cost of debt above the cost of equity. Therefore, by
price alone, the optimal capital structure is made up of all debt. The investor can
verify this concept by observing the demand for any stock that has a junk bond
status; the price of the stock deteriorates as the cost of its debt skyrockets, and the
stock becomes a tool for speculators. The risk of holding one thousand dollars
worth of stock is much greater than holding a one thousand dollar bond of the same
firm because the bond needs to be repaid or the stock will become worthless.
In the long run, a higher probability of bankruptcy will raise the cost of
capital, a direct correlation that is maintained at lower levels as well. In effect, the
cost of capital responds to the risk of bankruptcy in the capital structure and will
adjust to reflect the stability of the company. Capital structure, however, responds
slightly to changes in the cost of capital, mostly adjusting through the amount of
capital raised. When interest rates are high, for example, the company may not
change its target structure to a lower level of debt, but may adjust the amount of
funding for all projects and move slightly past its target with more equity funding.
When rates are lower, the firm begins to fund with more debt, moving past its
optimal target from the other direction. Only when there has been a systemic shift
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that will raise or lower the interest rate throughout an entire business cycle will the
optimal target change substantially. Such patterns occurred in the late 1970s with
massive inflation and double digit interest rates and again with near record low
rates in 2002 - 2003.
The student/investor should recognize that no level of interest rate will
ensure steady repayment of a loan because rates change frequently with the level of
GDP growth. For a firm who funds with all equity, taking advantage of “cheap
interest” for a short amount of time will merely cause the firm to suffer the
consequences of a poor decision; shareholders will sell the stock because too much
risk is incurred. On the other hand, firms whose asset structures have changed and
are more amenable to using debt, will receive an initial boost upwards as tax
advantages eclipse the cost of bankruptcy. For companies who use debt on a
regular basis, changes in rates give incentive to raise more capital but not to make
major changes in capital structure. In effect, a favorable change in the cost of
capital is an impetus to move well past the optimal target or even temporarily move
away from it altogether because the risk of doing so is rewarded with a lower cost of
capital. However, firms realize that such conditions are temporary and usually
move back toward the optimal target as soon as possible.
THE CONCEPT OF A WEIGHTED AVERAGE COST OF CAPITAL
The standard definition of “capital” comprises several component parts
including equity, long-term debt, preferred stock and some short-term debt and
capital leases. When the percentage of each component part in the capital structure,
using market values, is multiplied by its specific cost and then summed together, the
measurement that is formed is called the weighted average cost of capital or WACC
In the long run, the WACC will follow the probability of default either up or
down, but minimizes when the capital structure is optimal - at a point where tax
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benefits and bankruptcy costs are at their greatest distance. In the short run, there
may be eccentric movement because the market does not always price risk correctly.
When the government sets interest rates, it does so to preserve systemic equilibrium,
a balance between growth and inflation. However, a firm does not set policy to
conform to Federal Reserve decisions. It funds capital projects to make back its
investment as rapidly as possible. Therefore, there will be periods when the firm is
using more equity while interest rates for debt are decreasing and vice versa. Over
a two or three year period, the WACC is a reliable indicator of movement toward
an optimal capital structure; any decrease would be viewed as favorable. However,
it may rise from year to year simply because there has been a systemic shift toward
comparatively higher capital costs.
By using the amount of debt that keeps the cost of bankruptcy at a relative
minimum, yet maximizes tax benefits, the greatest amount of the least expensive
capital component is used. For firms who fund only with equity, the probability of
default is minimized with the same actions that will boost structural integrity and
decrease the cost of equity - stability of sales and income in the domain of higher
returns. Thus, an unlevered firm must minimize its WACC without the luxury of
substituting lower cost debt for equity. However, by minimizing bankruptcy costs -
keeping shares to a minimum and lowering the probability of default - it will also
minimize its WACC, producing an optimal capital structure. In most cases, the cost
of capital will be uniformly higher for all equity companies, which they need to
overcome by both increasing and stabilizing the amount of sales and income.
Figure 3-3
21
EARNINGS AND CAPITAL STRUCTURE
In the chapter on leverage we mentioned that the amount of fixed assets in an
industry will determine the stability of earnings and that financial leverage can be
increased when operating leverage is lower. However, the amount of earnings is
also a major factor in determining capital structure. When earnings are large, they
can be retained, and outside sources of funding (debt and new shares of equity) can
be avoided. In effect, large amounts of earnings tend to be unstable because of the
risk-return tradeoff, but enable a firm to build stockholders’ equity through
retained earnings.
When earnings are retained and become part of stockholders’ equity, they
incur the cost of equity. The full development of the cost of equity is left to another
chapter, but let it be stated that the cost of equity is a comparative cost very much
related to the return on equity, which is the ratio, Net Income / Stockholders’
Equity. Thus, if the cost of equity is particularly high, it will cost the firm more to
retain earnings than to distribute them as dividends or buy back shares of stock. In
this regard, dividend policy is very integrated with capital structure because it
determines retention and the ultimate WACC.
Debt / Equity
Dollar
Value
WACC
TB - Cost of Bankruptcy
22
Another effect of earnings on capital structure is the minimization of the
probability of default. Most default algorithms explicitly define some aspect of
earnings as a variable that diminishes this probability. In the marginal benefits
equation, a smaller probability of default allows more debt funding, more shares, or
some combination of both - capital appreciation that leads to asset growth.
Inevitably, to preserve tax benefits, the proportion of equity grows through
retaining the same earnings that diminished the probability of default; the marginal
benefits function can grow when equity is added to debt but does not replace it.
Only when the cost of equity is considered too high will share buybacks and special
dividends need to be considered in lieu of retention.
The business cycle determines when certain industries will have favorable
sales and earnings. Consequently, an entire sector will exhibit similar patterns of
marginal benefits and leverage that will be dependent on the probability of default.
In a downturn, high tax benefits will be accompanied by an even higher probability
of default because firms are generating less income; they must pare down their debt
above all else. In expansions, more income lowers the probability of default
allowing more tax benefits. The effect of an optimal capital structure, however, is to
reduce the negative effects of the business cycle and to accentuate the positive. The
cost of capital is kept low enough during a downturn so that competitive progress
can be made. Consequently, during an expansion, the company will have the
financial flexibility to take on more risk, and sometimes even the luxury of moving
away from the “safe” environs of an optimal capital structure.
CAPITAL STRUCTURE LOGIC
Capital structure theory displays a pattern of alternating risks and returns
that are encapsulated in several measurements. Each category of risk stems from
the previous category and has a corresponding set of measurements. In the
23
following chart, to get to the highest level, capital allocation, the other risk
categories must be properly assessed.
24
Table 3-1
HIERARCHAL RISK RISK / RETURN MEASUREMENT 1) CAPITAL ALLOCATION
1) COST OF CAPITAL
a. Proportion of debt to equity
a. Cost of debt
b. Project analysis b. Cost of equity c. Capital budgeting c. Cost of various other
components d .Capital Requirements d. WACC e .Capital market conditions
e. ROE, ROC, Economic Profit
2) BANKRUPTCY RISK 2) COST OF
BANKRUPTCY
a. Probability of default a. Measurements and risks are the same.
b. Amount of loss 3) FINANCIAL RISK 3) LEVERAGE RATIOS a. Interest expense a. Financial leverage ratio b. Number of equity shares
b. Equity multiplier = Assets / Equity
c. Tax Benefits c Change in Net Income / Change in Operating Income
d. Stability of net income and operating income
d. TIE (Times Interest Earned)
4) ECONOMIC RISK 4) OPERATING RISK a. Sales a. Operating Leverage b. Fixed and variable costs
b. Capital Intensity
c. Operating Income c. Operating Margin
CHANGES IN CAPITAL STRUCTURE AND STOCK PRICES
“Like a monkey throwing darts,” has been a common description of the
random variation that analysts face when picking individual stocks. Indeed, any
25
system that purports to comprehend some of the mismatches in risk and return
throughout the years, including capital structuralism, appears to be a blind attempt
to rationalize chaos by giving it meaning. However, the one to three year time
frame of capital structure analysis does give it some perspective. Although
historical patterns seem to repeat themselves “with a new twist,” capital
structuralism does not try to forecast stock prices; it only attempts to identify an
environment conducive to increasing them. In fact, the same dynamics that proved
successful for IBM in the 1960s have been proven successful for Google in the new
millennium; both companies have worked diligently to optimize their respective
capital structures. While the “devil is in the details,” these firms have improved
stock price by increasing the flow of earnings toward shareholders - mostly through
capital gains. In effect, the ability to keep earnings expectations high has been the
prime ingredient in stock price appreciation. By staving off bankruptcy costs and
keeping the cost of capital low enough, earnings have been magnified in comparison
to the competition. Neither company worried about the “clientele effect” of keeping
their share prices too high and not splitting them; the premium was placed on
minimizing the number of shares outstanding.
Most improvement in stock prices happens concurrently with earnings
improvements. If this were not so, “investing after the fact” would be profitable and
simple. Although some money is made off of “momentum” in some markets, Wall
Street tries to separate investors into two categories: those who make good
judgments well ahead of time, and then everyone else. In fact, most firms will reach
an optimal capital structure some time during a business cycle and do so when their
entire sector is dominating the market. If the housing sector is dominant, for
example, the paint companies will not be far behind. It is a cycle of matching the
opportunities created by the relationship between interest rates and equities, with
the structure of the firms that can most take advantage of it
26
As an example of a very typical scenario, consider the hypothetical XYZ
Company. At the top of a business cycle, they have now increased debt to equity for
two years in a row, and they are well past their optimal capital structure with too
much debt. Their earnings have been tepid, but now they sense that their
investment in Chinese furniture is going to be a “cash cow” and pay off. In the
third year of their investment cycle, sales jump twenty-five percent. Consumers
have money to spend. Increased earnings move the stock up thirty percent and the
firm decreases its debt to equity ratio by paying off some of its loans and retaining
earnings. Investors who entered this game early enough receive the spoils of
victory. After two years of diminishing its debt, the firm may be past its optimum in
the other direction, and investors begin ignoring the stock because returns are not
as substantial. At this point, the firm needs to regroup and fund new projects with
a higher risk - which may again mean increasing its proportion of debt.
Dart throwing monkeys notwithstanding, some of the volatility in the market
is attributable to business cycle fluctuations; those firms with the greatest operating
risk can only perform for a brief amount of time when their particular sector is
favored. The performance of such firms may entail an eighty percent rise in the
stock price over two or three years, followed by weak or even negative results.
Lower total leverage (operating leverage multiplied by financial leverage) will
buffer some of the effect of the business cycle, but even low-risk firms will have brief
periods of wild profitability followed by below average results.
How does the business cycle suddenly match a firm’s structure with the
pattern of available funding? Each firm has an optimal proportion of debt to equity
that responds to the level of interest rates and their relationship to equity. Firms
who have low operating risk, for example, may use more financial leverage and fund
projects when interest rates are low at the beginning of a recovery. At this point,
the firm’s earnings will begin to far outpace the cost of capital, and its stock price
27
will soar. However, this type of opportunity can only be realized when the firm is
moving toward its optimal capital structure; the distance the firm needs to travel
actually accentuates both the risk and the return.
FOUR “POSTULATES”
In the world of equities, hard and fast rules “break like twigs” and so we call
these observations “postulates” with the knowledge that each will be broken at some
time or other:
• 1) All variables held equal, more earnings tend to decrease the proportion of
debt to equity (D / E), because the firm will pay off some loans and/or increase
retention.
• 2) Companies who simultaneously and substantially increase both debt and
earnings may pay out in income taxes much more than they have deducted in
interest tax savings. It is no coincidence that companies time their debt issues
when earnings are lower.
• 3) The greatest stock returns occur when earnings are accelerating upward
while the cost of capital is accelerating downward.
• 4) Small blocks of debt are prohibitively expensive because there are economies
of scale when bonds are issued. Firms who garner large loans usually do so with
strategic purpose. Alternatively, firms who increase debt by small amounts on a
constant basis may have cost overruns or problems with remaining solvent.
LIMITING THE AMOUNT OF SHARES
The effect of financial leverage is to reduce the potential number of shares
outstanding by funding with debt instead of equity. The firm receives a tradeoff
between the potential amount and variability of earnings per share because net
income and market price are not diluted by more shares outstanding. However,
given a choice, most firms would fund with sufficient retained earnings as long as
dividend growth were adequate. The fact that a firm needs to make a choice
28
between the “lesser of two evils” (debt or more shares) is indicative of the
inadequacy of internally generated funds.
This insufficiency is not a pejorative. Many industries do not have the
earnings capacity to do continual internal funding. These are well-managed and
profitable companies who happen to be in an industry that have historically low
margins. In fact, their ability to increase their stock price rests wholeheartedly on
managing a capital structure that has higher amounts of debt because operating
leverage is so low; large increases in sales will translate into small increases in
operating income. The premium is placed on keeping share issues to a minimum,
and even limiting retained earnings by paying a steadily growing dividend. This
type of control over capital structure allows these firms to compete in markets that
have players with profit margins five to seven times as much. In fact, any quick
statistical survey will find that industries with more debt tend to have less stock
price volatility - which seems to be an anomaly - until one considers that firms with
less operating risk can incur more financial risk.
Firms who are funded with an all-equity structure face a “double-edged-
sword.” On the one hand, they are usually very profitable - periodically - and fund
their projects internally from retained earnings. On the other hand, the need to
compete and replace a high level of fixed assets requires a constant source of
funding which further requires these firms to issue shares of stock. Since debt is
unwarranted given the level of operating risk, these firms will dilute their EPS and
market price with more shares outstanding. Thus, the more stable and large is their
operating income, the fewer shares need to be issued. Those “diamonds in the
rough” that are fortunate enough to have a high operating leverage with stable sales
can fund all of their needs with internally generated retained earnings. However,
these companies are usually small, and when Wall Street requires them to grow,
29
there will be some tradeoff made between stability and the method of financing, i.e.,
more shares outstanding.
ADAPTED MEASUREMENTS
This text accentuates the tradeoff between long-term debt and common
equity. While other sources of funding may diminish risk, the crucial components
are the amount of long-term debt and common equity because these require the
most expense and obligation. The definition of capital may include adjunct sources
of capital like short-term interest-bearing debt and preferred stock, which are
typically incurred under special circumstances. When comparing firms, however,
concentrating on long-term capital obligations will expedite analysis.
For both the investor and financial management, the focus needs to be placed
on evaluating the firm through its long-term capital obligations because the success
of the company rests on their viability. For example, instead of alluding to the
proportion of debt to equity (D /E), we concentrate on long-term debt to capital
(LTD/ CAP) which is more sensitive to change (mathematically) and better
elucidates the tradeoff between capital obligations. Moreover, we use the ratio,
return on capital (ROC) more than the ratio, return on equity (ROE), simply
because in our more narrow definition of capital, the figure is more resistant to false
interpretation. Another example applies to the weighted average cost of capital
(WACC). By narrowly defining capital, we eliminate some of the risk adjusting
effects of other sources like short-term debt, and form a cost that is dependent on
long-term debt and common equity; we trade technical accuracy for a better gauge
of the risk between these two components.
EXPLICIT VERSUS IMPLICIT COSTS
We are already familiar with some of the explicit costs of capital structure -
those paid in an actual exchange of cash. Costs are made up of fixed and variable
varieties that together make up the total cost when operating income is subtracted
30
from sales. Some of these costs include: wages, rent, machinery maintenance,
materials and office supplies. Interest expense is indeed a prominent explicit cost
that needs to be paid regularly. However, no less important are what are termed,
“implicit costs” - costs that have an effect on the price of the stock but are difficult
to enumerate because they do not represent a physical asset. In effect, since capital
structure analysis involves making choices between competing actions, many of its
decisions are based on these inherent “implicit“ costs.
One of the most familiar implicit costs is dilution. If the XYZ Company has
100 shares of stock, each with earnings of one dollar, increasing the number of
shares to 110, will have an implicit cost of (1 - (100/110)) x(110) = 10 dollars. The
action of increasing outstanding equity by ten percent had the net effect of reducing
EPS which has an effect on the price of the stock, but does not reduce the
fundamentals on the balance sheet.
Another implicit cost stems from delaying actions. For example, I can
choose not to install pollution control equipment and incur a small fine (as wicked
as that seems), or I can spend too much for a system that will be both less expensive
and obsolete in a few years. The “fine” will become part of the balance sheet, but
the decision to delay and save money has no corresponding entry.
Since capital structure analysis encompasses decisions about choices among
alternative actions, the primary implicit cost is termed an “opportunity” cost, a gain
or loss that occurs when we choose one action over another. Thus, an opportunity
cost implies that we are comparing the cost of two different actions. For example, if
bonds are paying six percent and stocks are paying nine percent, my opportunity
loss is three percent if I choose bonds over stocks. A comparative return on equity
(ROE) of competitors in an industry exhibits many of the characteristics that we
term, “the cost of equity”; there is no physical, “up front” cost, but if my firm
underperforms its peers in ROE, there is some adjustment made to the stock which
31
is difficult to predict or enumerate. In fact, any time that an analyst researches
industry averages, some type of comparative paradigm, an opportunity cost so to
speak, is being formed in his or her mind. Thus, we often form these costs
unconsciously.
IMPLICIT COSTS OF DEBT
Naturally, interest expense is the explicit cost of debt and tax deductibility is
acknowledged when we use it to form the cost of capital. However, several other
implicit costs exist when debt is incurred.
• 1) The interest rate needs to be compared to not only competitors’ rates, but to
the risk-free rate of the ten year treasury and the averages in the equity markets
as well. If it is too high, debt needs to be curbed and more earnings need to be
retained.
• 2) The ‘real” cost of interest may not only include tax deductibility but inflation
as well. High inflation has a varying effect on firms with good credit because
assets appreciate while loans are paid off in depreciated dollars. The cost to
some firms is excruciating.
• 3) The cost of bankruptcy is always implicit unless the firm is actually
bankrupt. The firm needs to determine which assets can be secured as collateral
in addition to the immeasurable effect on the stock of changes in the probability
of default.
• 4) The effect on the cost of equity must be determined. If more leverage raises
the return that investors require to invest in a firm’s stock, can the firm be
profitable enough to warrant the increase in debt? Will demand for the stock
actually decrease, if some threshold amount of return is not surpassed?
• 5) The implicit cost of possible asset impairment must be examined. Some
restrictive covenants in bond indentures restrict the use of assets and put other
restrictions on the actions of management.
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• 6. The implicit cost of impairing future financial flexibility must be examined.
Even if interest rates decline, there is some cost to refinancing a loan. Similarly,
no firm wants to be laden with debt at the top of a market because this is the
point of greatest earnings opportunities for most companies.
THE IMPLICIT COST OF EQUITY
The cost of equity is the rate of return that investors will require to invest in
a firm’s stock. It is used synonymously with the term “required rate of return” and
is referred to as an “opportunity cost” because it compares the rate of return of
firms with similar risk in a least squares type correlation. When equity is issued,
the only up-front costs will be “flotation costs” which are a payment or a percentage
of the proceeds to the underwriting firm. When equity is built through retained
earnings, the required rate is applied to all retained earnings (not just the current
year’s) as well as all outstanding stock that has been issued by the company. Thus,
the “cost of equity” is almost entirely implicit and shifts in value from year to year
depending on the rate investors will require. In a “bull” market, this rate naturally
rises, while in a “bear” market, it declines.
Another implicit cost arises in the timing of a stock issue. If a firm is
“maxed” out on its credit and is not earning enough to raise capital through
retention, it must meet its funding needs through issuing stock. However, the price
received will be diminished because investors will not find the stock attractive; if the
firm has a target level of capital requirements, it will need to issue many shares to
achieve it. Thus, there is a threshold point where funding should be delayed or
avoided because it diminishes the market price of the stock too drastically.
Alternatively, a firm can issue stock when the price is high, receiving the most
capital per share issued. This latter tactic raises adequate capital, but may be
undertaken when the cost of equity is very high - such as at the end of a business
cycle. When the cost of equity (the required rate of return) is exceptionally high, the
33
firm may have trouble covering it with adequate earnings. The result is often a
large adjustment downward because performance does not meet the over-hyped
expectations. The final strategy is most preferred by insiders and large investors:
issue stock when the price is low enough to appreciate substantially. When the
market has not factored in expected earnings from projects that it knows nothing
about, the risk and cost of equity is low. However, the company’s capital structure
must be viable enough not to depend on a stock issue for its total funding; any CFO
knows the value of a diversified mix of sources of funding. Any time that a firm
depends too much on a single source, there is more risk of a higher cost of capital.
To summarize the implicit costs of equity, we can put them into one of three
categories:
• 1) The implicit cost of dilution - The firm must consider the effect on both EPS
and market price, as well as future dividend obligations.
• 2) The implicit cost of the “required rate of return” - Investors will not demand
the stock of a company that underperforms its peers. A firm that does so will
have a very high “opportunity cost” and be unable to cover it with enough
earnings.
• 3) The implicit cost of timing. Raising large amounts of capital with an equity
issue has many repercussions. The only time it seems justified is when a major
merger occurs in a favorable economic environment. Thus equity issues should
be relegated to “executive currency” rather than exist as a major source of
funding.
THE MOMENT OF TRUTH
Ultimately, most investors want to time the market so that they are in the
early stages of a large payoff. More often than not, that scenario occurs to any
investor who is well diversified and stays in the market long enough, despite its
volatile changes. It is not a frequent occurrence. If the student/investor observes
34
the corporate side of any investment, he or she will understand it as a shift in capital
structure where accelerated earnings begin to propel the combinations of assets,
debt and equity in a particular direction. The uncertainty is derived from the
timing of that prospect and whether it will occur at all. Naturally, it is the
prerogative of management to keep lag time between investment and payoff to a
minimum. Some industries, however (like pharmaceuticals), will have a long lag
time but return more once the payoff occurs. In fact, more than one investor has
left a firm only to find that more patience would have led to profitability.
Inevitably, investment screens are designed to fail because the market will change
and make sure that they do. But - there are a few signals that are related to both
capital structure and early investment success.
• Executive Trades. When a company’s own executives are buying stock and are
doing so from a leveraged position, the tide may start shifting to more equity
financing.
• Although financial statements occur “after the fact,” look for quarterly
improvement in capital turnover, % ∆∆∆∆ Sales / % ∆∆∆∆ Capital or % ∆∆∆∆ Sales / % ∆∆∆∆
Long-term debt
• Investing in a company who is increasing its proportion of long-term debt to
capital is riskier than investing in a company who is building equity. However,
the return can be greater if the firm knows how to use debt strategically. The
risk should be accompanied by some confirmation from analysts that earnings
are going to improve.
• Look for a shift to a smaller proportion of long-term debt to capital as well as a
shift to a lower financial leverage ratio (EBIT / (EBIT - Interest Expense)). At
first, the two ratios may be “out of sync”; when earnings increase, the financial
leverage ratio will begin to drop in harmony with the other ratio.
35
• Know the business cycle. For example, expecting large gains from the housing
sector at the top of the market may be wishful thinking. Earnings accelerate
when a sector is receiving high demand at the same time that its capital costs are
low.
(Back to Table of Contents)
36
APPENDIX: THE NET OPERATING INCOME APPROACH TO STOCK
VALUATION
(FOR ACADEMICS)
Student/investors are advised to take the most conservative approach to
valuing a stock. While more leverage may escalate the price of a firm’s stock in a
world without bankruptcy, reality dictates that returns must be evaluated in the
domain of risk. Academicians developed two methods to contrast opposing views.
The first method was called the “net operating income” method and postulated that
the extra return from leverage was balanced out by the extra risk, contributing no
additional value to the firm. The second approach was the “net income” method
which proclaimed that a firm’s value was an extension of its degree of leverage, and
the relationship between its interest rate and the cost of capital. Both approaches
were developed in a hypothetical world of “perfect competition” - no taxes,
bankruptcy costs, or different rates of interest between firms and individuals.
While both methods value a company as the sum of its bonds and its stock,
the net operating income approach determines the value of the company as the ratio
of capitalized operating income: that is - operating income divided by the cost of
capital. It then subtracts the value of the firm’s bonds to determine the value of its
stock. In mathematical notation, the value of the stock is : (X / Cost of Capital) -
Bonds, where X is equal to operating income. On the other hand, the net income
approach to valuing a firm’s stock subtracts interest expense from operating income
and then divides this difference by the cost of capital. In mathematical notation it
is: (X - (Interest Rate)(Bonds)) / Cost of Capital. It then takes this value of the stock
and adds the value of its bonds to determine the value of the company. As an
example of the two approaches, consider a firm that is capitalized at $10000 with
D/E of 0 %, 50 % and then 100 %. Operating income is $1000 and is capitalized at
10 %. The interest rate on bonds is 5 %.
37
38
Table 3-3
Net Operating Income Method
D / E Percent 0 50 100 Net Operating income
1000 1000 1000
Capitalization Rate 10% 10% 10%
Total Market Value of the Company
10000 10000 10000
Market Value of Bonds
0 5000 10000
Market Value of the Stock
10000 5000 0
Table 3-4
Net Income Method
D / E Percent 0 50 100
Net Operating Income
1000 1000 1000
Interest Expense at 5 % on Bonds
0 250 500
Net Income 1000 750 500 Capitalization rate 10% 10% 10% Market Value of the Stock
10000 7500 5000
Market Value of Bonds
0 5000 10000
Total market Value of the Company
10000 12500 15000
By capitalizing operating income and deducting interest, the net income
approach adds a substantial amount to both the market value of the company and
its stock. However, the net income approach assumes that there is no risk; all
increases in EPS are immediately transferred into the price of the stock.
39
Alternatively, the net operating income approach assumes that the risk of leverage
perfectly balances the potential effect on EPS and that risk and return cancel each
other out. In the net operating income approach, the value of the company is
calculated first, and the amount of bonds is subtracted to determine the stock price.
In the net income method, the value of the stock is calculated first, and the amount
of bonds is added to this figure to determine the value of the company. The
student/investor will observe that if the interest rate is the same as the cost of
capital, there is no difference between the two methods; indeed the net income
method rewards management for keeping both rates as low as possible.
Miller/Modigliani argued that the only correct approach was the net
operating income method. Their Proposition I argued that in a world without taxes,
no gain would be garnered from leverage because the interest rate would always
approach the capitalization rate. Thus in a perfectly competitive economic
environment where individuals and firms can lend at the same rate ( no
bankruptcy), there would be no benefit from the proportion of debt to equity in the
capital structure. The same amount of earnings would flow to the shareholders
regardless of how the firm was funded.